Tag Archives: stock index

Protecting Stock Market Gains

This is the third cautionary report I’ve written on the stock market in six weeks. The last time I focused this heavily on the stock market was in early 2009. Back then, I was making a point to everyone who’d lost their shirt on the way down that employing the leverage provided by stock index futures contracts would be a great way to recoup some of their lost funds when the market bounced. This week, we’ll discuss the same strategy only in reverse. I’ll explain how to use leveraged futures to protect your equity portfolio ahead of time in case you haven’t taken the appropriate actions.

Continue reading Protecting Stock Market Gains

Spread Trading the Russell 2000 Vs. S&P 500

The stock market has made a lot of noise this week with the Dow Jones Industrial Average climbing above 15,000 for the first time in history. In fact, all of the major averages are up about 18% year to date. There is a general consensus that the massive liquidity operations the Federal Reserve board has implemented are the primary contributor to the market’s rally. However, there are several competing theories as to where the top may be. This week, we’re going to take a look at seasonal tops in the Russell 2000 small cap stock index compared to the S&P 500 large cap index to try and lock in some profits while minimizing downside risk.

The Russell 2000 is a stock index made up of small companies with a median market capitalization value of around half a billion dollars. This compares to the S&P 500 market capitalization average of nearly 28 billion dollars. Another way of putting this in perspective is that the Russell 2000’s largest company by market cap is Alaska Air as compared to the S&P 500’s largest company, Apple. The important thing here is to differentiate the small cap growth stocks of the Russell 2000 from the large caps that make up the S&P 500.

The reason for this is that small caps and large caps tend to behave differently. Small caps tend to lead. Therefore, they overshoot the tops and the bottoms. The smaller nature of the stocks in the Russell 2000 means that it takes less money to move the underlying stock. Small companies are also easier to grow. Of course, extra growth comes with extra risk. The composition of the Russell 2000 changes regularly due to new companies being added while others are removed. The large cap indexes like the S&P 500 are more stable due to the massive size of the companies it’s comprised of. Steady, stable, predictable growth is what is hoped for in the S&P 500.

We’ve all heard the old adage, “Sell in May and walk away.” There is a bit of truth to this as the primary stock market gauges are typically flat through the summer with a bit of upside bias and lots of downside volatility. In fact, this seasonality is even more pronounced in the Russell 2000, which tends to bottom in August. In other words, growth is minimal while full risk exposure remains. This is not an ideal risk to reward scenario. Over the last ten years, the Russell 2000 has called the late spring / early summer top correctly eight times. The two years it was wrong were 2008 and 2009 when the markets had already been beaten down. The average profit on the trade I’m about to detail was $4,250 for the other eight years.

There are two different ways to lay this trade out. The complicated way would be to find the least common multiple of the underlying futures contracts and work out the rest of the equation as percentages and then translate the percentages back into dollars and cents. Fortunately, we can simply use the futures contracts as they are and buy an S&P 500 futures contract while simultaneously selling a Russell 2000 futures contract.

This application takes advantage of the Russell 2000’s larger built in multiplier. Calculating the value of the Russell 2000 futures contract is as simple as multiplying the index by its $100 multiplier. Thus, a June mini-Russell 2000 contract trading at 970.00 has a cash value of 970.00 X $100 = $97,000. Meanwhile, the mini-S&P 500 has a built in $50 multiplier. Therefore, the mini-S&P 500 futures contract has a cash value of 1625.00 X $50 = $81,250. Buying one mini-S&P 500 futures contract and selling one mini-Russell 2000 creates a net short cash value of  $15,750 worth of small cap stocks.

The maximum value for this spread position was $16,671 in May of 2011. This represents the farthest the Russell 2000 futures have climbed above the S&P 500. We recently made a high of $16,200 two weeks ago.  Currently, this spread is trading at $15,350. I expect the recent April high to hold. If the market trades above the recent high of  $16,200, I will exit the trade at a loss. Recently, the average price for this spread is around $11,500. Therefore, I will use this support as the first place to look for profits. This sets up a trade that is slightly short the stock market through exploiting seasonal and market capitalization biases. Furthermore, this trade has had a relatively high historical winning percentage and is currently providing us with a 4-1 risk to reward ratio.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Commercial Trader’s Role in the Stock Index Futures

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

The stock market’s recent sell off between 7.5% and 14% depending on the index, was immediately followed by five straight day’s worth of rally. Apparently, the TV pundits are saying that the electronic meltdown was just what the market needed to attract fresh buying to the markets and push them back to 2007’s happy market levels. Unfortunately, based on commercial traders’ positions, they don’t seem to share the talking heads rosy outlook. In fact, their trading actions appear to favor, “The Coming Double Dip,” opinion.

Throughout the month of April, commercial traders have been steadily building short positions in the stock index futures. The behavior of the institutional trader is to vary their short position in the stock indexes to offset their perceived sense of risk in the stock positions they currently own in their portfolios. The execution of short hedges in the stock index futures allows them to hold on to their individual issues. The ability to protect their portfolio without having to sell individual issues also protects them from incurring capital gains penalties on their core positions. Thus by tracking commercial traders’ momentum we can get a feel for not only their positive or, negative outlook on the stock market but also their sense of urgency.

Individual investors need to know what options are out there to help them protect their hard earned equity portfolios. The stock index futures offer direct hedges to the Nasdaq, Dow, S&P 500 and Russell 2000 indexes. These markets cover everything from blue chips to heavy tech and small cap. They also trade in various size contracts to help tailor hedge positions to your underlying investments.At these levels, the small contracts have approximately the following cash values:

Market                 Cash Value        Margin RequirementS&P 500                      $56,500                  $5,625Dow Jones                  $52,500                  $6,500Nasdaq                        $18,750                   $3,500Russell 2000                $68,000                  $5,250

Using the above values, one can see the effectiveness of using futures to hedge an equity position, rather than a Contra, Profund or, other inverse equity mutual fund through the following example.

John Doe has $250,000 in equity positions through individual stocks, mutual funds and retirement plans. John is afraid that the market’s rally has run its course and given the overall economic outlook, would like to be able to protect his portfolio in the event of a downturn. Unfortunately, John has had some of the individual stocks for so long that his cost basis makes selling them and paying capital gains taxes an unappealing option. Several of his mutual funds are held in various retirement accounts run by managers who don’t solicit investment advice from their clients on a regular basis. Finally, John has another $75,000 in cash, short term rates and money markets. He considers this his operating cash for any opportunities or emergencies that might come up. So, what can John do protect his self in the event of a market downturn without tying up all of his free cash?

Assuming he would like to hedge half of his portfolio, he would determine the makeup of his holdings to see how he’d like to balance his hedge – small cap, blue chip, tech, etc. Now, he wants to give himself room for another 10% higher in the equities due to the “January Effect” or, market exuberance. Therefore, the free cash needed for this strategy would be approximately, $16,000 in margin to carry the equivalent of a $125,000 short equity mutual fund. Plus, he’s going to need an extra $12,500 to provide a cushion of another 10% rally in the equities. His total free cash outlay is $28,500. Thus, he effectively hedges half of his equity position while tying up only 25% of his operating cash.

The commitment of traders report for the stock indexes can be a good barometer for anticipated movement in the stock market. Furthermore, through the use of stock index futures and a competent broker, individuals can implement the same type of equity protection as the big boys.

Please call with any questions.Andy Waldock866-990-0777

Is the Commodity Pullback Over?

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk in investing in futures.

The last two weeks have brought considerable pullbacks in major trends including, the stock indexes, metals, grains and energies. We’ve also seen the most convincing U.S. Dollar rally in a year. This seems like a good place to take a step back and assess our positions on the broader markets.First, let’s break down the numbers and the correlations. The march of the commodity rally has been timed by the Dollar’s decline for nearly a year. Over the last month, we’ve seen the Dollar rally about 4% off of its lows. The rally became news over the last three weeks. Looking at a weekly chart, one can see that this is the first time the Dollar has taken out a previous week’s high and not immediately, closed lower the following week. Fortunately, we were able to see that the commercial trader’s momentum by using the Commitment of Traders Report had turned bullish on the Dollar beginning around Christmas time and we finally published a buy signal on January 19th’s COT Signals.The issues facing the commodity markets are twofold. First, the Dollar’s decline made our raw materials cheaper to purchase on the world markets. Secondly, as the commodity markets rallied, Commodity Index Traders, (CIT’s), are forced to buy more futures contracts as the value of their index rises. They are required to maintain a certain percentage of their indexes value allocated to the markets as stated in their prospectus. Consequently, as the commodity markets have declined, they’ve been forced shed contracts to maintain their waiting. Their influence on the markets can be seen in the disproportionate moves in the commodity markets – both on the way up, and on the way down. This is one of the reasons why the Dollar’s 4% rally has created the following declines:6.5% – 8% in the stock market15% give or take, in the grain markets15% in silver10% in platinum5% in gold14% in crude oil13% in unleadedOak, so where do we stand? Throughout this decline, the Commitment of Traders Report has seen commercial traders increasing their rate of buying in the raw materials markets and increased their selling in the stock indexes to correspond with their buying of the Dollar. We have watched the momentum of their purchases increase in the raw materials just as the Commodity Index Traders positions have declined and watched the opposite hold true in the negatively correlated U.S. Dollar vs. stock indexes. This is the classic example of why we follow the momentum of buying or selling within the commercial trader category. We’ve been patiently waiting and waiting with relatively few trading opportunities. As of Friday, we reached oversold levels in many of the markets that still maintained bullish momentum. Beginning on Tuesday’s trade, our proprietary indicator began ticking out buy signals in the energies and metals. This was followed immediately with buy signals 9 other markets. This means that our methodology has kicked out 16 buy signals in the last two days. That’s 16 buy signals out of 36 markets tracked. Finally, I would like to briefly note the background themes over the last month as this has built. We have the Dollar devaluing concerns of the health care bill which were mitigated by Brown’s victory. The equity market concerns over earnings realized through labor market cost savings and finally, the governmental budget issues which are beginning to kick out inflationary signals in our own programs. Our end of January position leaves us with reasonable demand for raw materials and inflationary concerns over the bond market leading to weakness in the stock indexes.